Last updated: 09:02 / Monday, 10 March 2014
MFS Strategist Corner

Can that Cool App I Created Make Me a Billionaire, Too?

Can that Cool App I Created Make Me a Billionaire, Too?

Just about everyone is entranced with the recent news out of Silicon Valley about billions of corporate dollars being used for acquisitions. Many of the buyouts we’re hearing about are software companies that were startups just a few years ago. There is almost an 1849 Gold Rush mentality now in California. Who can think of the next software application that can be sold to a big Internet company for billions of dollars? Basement and garage software entrepreneurs work feverishly, hoping their ideas can make it big.

But what do company takeovers and buyouts mean for those of us who invest in the market? The first question is always fundamental. Are we witnessing mergers and takeovers that add value? If most of the M&A activity is being undertaken to improve cash flow growth in the long run, everyone should be better off. Usually, however, this isn’t the case.

While many types of acquisitions can add to shareholder value, many others don’t. Some company transactions are deliberately designed to spread another revenue stream over a fixed cost base. If these transactions are executed well, shareholders stand to benefit from higher margins and higher returns on capital. One example of this might behorizontal integration — buying a similar company in a similar business and keeping the revenues but not duplicating the costs.

Another case might be vertical integration — buying another company along the supply chain to obtain ease of control. Some examples include a manufacturer acquiring a sales company, an energy extractor purchasing a gasoline refinery or an Internet retailer obtaining a money transfer firm to help control the financing aspect of selling goods and services online.

A third type of positive takeover could be carried out for diversification. Just as investors often seek to balance the risk in their portfolios by diversifying their holdings, companies may want do the same by diversifying their business lines. Buying other companies may be able to buffer the effects of the economic cycle, smoothing out earnings as one business does better while another is flagging.

All three of these fall into my category of legitimate or worthwhile motivations for M&A. How do we detect if the reasons to take over a company are not so legitimate?

First, look at the motivation behind the acquisition. When a company exhausts its own organic growth, or stalls in its internal growth, management may be tempted to reach out and buy growth. The academic literature suggests that these growth acquisitions often involve overpayment and widespread destruction of shareholder value. Other companies use acquisitions to take out the competition or to find ways of getting around investing in their own businesses. In these cases, the less than noble outcome is typically that management is enriched, but not shareholders.

Second, consider what companies are paying for their acquisitions. During typical cycles, the price paid to take over another company must involve a premium to get existing shareholders to willingly part with their shares. Again, academic research shows that in many buyouts and takeovers, the buyer pays too much and the result is grief for the shareholders of the acquiring firm. Typically the premium paid is 30% or 40% over the current market price.

These are things to look for when selecting individual companies.

In a broader sense, I like to watch M&A activity for its ability to indicate trouble ahead for the market or to confirm that a market peak is approaching. Looking back over history, we see that market peaks and recessions have frequently been preceded by periods of wild or excessive M&A transactions. Takeovers in these euphoric periods typically reach 7% of the names traded in the public marketplace. Now, takeovers are running at only 3% of publicly traded names.

We are definitely seeing some marquis takeovers and glittery deals, and most of them are taking place in the rapidly changing world of technology. There is a scramble across that sector to chase after global audiences for more advertising revenues.

Despite these high-priced deals, there is not yet a broad-based wave of mergers going on in the rest of the market. In fact, the rate of mergers is at or below historical averages. And on the valuation front, the current premium or buyout price paid for the average non-technology takeover is also below the historical norm.

We are watching this M&A trend, and right now it’s anyone’s guess if the cash-rich giants of Silicon Valley are making wise takeover decisions. But until the mania spreads — and we see high price tags in other sectors of the market, such as energy, consumer discretionary and staples — the time for worry hasn’t yet arrived. Based on historical averages, the M&A indicator is rising, but remains well below the danger threshold for the market as a whole.

Column by James Swanson, MFS Chief Investment Strategist